Deals

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

Shareholders of brokerage and asset management firm LPL Financial shouldn't hold out too much hope for a takeover. 

LPL closed 6.9 percent higher on Tuesday after a Reuters report said it was exploring a sale, among other strategic alternatives. But by Wednesday, LPL had shed as much as 4.9 percent on concerns a transaction may be less likely than first thought. Those concerns seem warranted.

Overvalued?
Most Wall Street analysts believe the brokerage firm's shares are overvalued. Out of the 12 surveyed by Bloomberg, not one has a "buy" recommendation on the stock
Source: Bloomberg

Two particular hurdles to a deal  are "insurmountable," according to analysts at Nomura. The first is the impact of the Department of Labor's new fiduciary rule (my colleague Nir Kaissar has written about this extensively, but essentially it requires brokers who work with retirement accounts to act as fiduciaries and put their clients’ interests ahead of their own.) Implementation of the rule could impact the brokerage's future earnings and it may face increased litigation risk from potential violations.

Then there's LPL's negative tangible common equity balance, a measure used to evaluate a financial institution's ability to deal with potential losses. LPL's TCE sat negative $985 million as at June 2016, which largely rules out any regulated bank as a buyer because of the impact to its own capital ratio. 

Potential Squeeze?
An acquisition of LPL Financial would hurt its shorts. The number of investors betting against the brokerage firm is close to its record high of 22.3 percent.
Source: Markit, Bloomberg

Notably, the Reuters report mentions private equity firms as potential suitors. LPL previously counted Hellman & Friedman and TPG as its majority owners: The duo bought their stake in 2005 and Hellman & Friedman exited in 2013. TPG still owns 9.6 percent, and last sold shares as part of a buyback last December that gave rise to a class-action lawsuit. 

At a 30 percent premium, any private equity owner would have to pay around 11.7 times LPL's trailing Ebitda, which isn't overly expensive. But with LPL's debt-to-Ebitda ratio already exceeding 3, meaning private equity buyers wouldn't be able to heavily lean on borrowings to finance a deal. 

To be sure, an all-cash deal at the same premium would likely be accretive for potential strategic buyers including Raymond James Financial, Charles Schwab and E*Trade Financial even without accounting for synergies, according to data compiled by Bloomberg. But any would-be suitors have the advantage of choice, as closely held online brokerage Scottrade Financial Services is also exploring a sale. 

It's also interesting that Marcato Capital hasn't stuck around. The activist investor that owned 6.3 percent of LPL this time last year said it would seek talks reviewing the company's general strategies and capital structure, but appears to have retreated -- with a likely loss in tow. 

If LPL's strategic alternatives don't culminate in a sale of the entire company, what then? Another buyback seems out of the picture per its CFO's recent comments that the company must shore up its balance sheet first (though he also said the company would be "excited" to snap the stock up at what he believes is a "compelling price"). That leaves a partial stake sale to a private equity firm, known as a private investment in public equity, or PIPE.

By structuring any PIPE deal as a convertible note, a financial investor could eliminate some of the downside risk -- which seems necessary in this case.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net